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A study on cointegration between indian and

american stock markets


* Dr. M.V. Subha ** Mr. S. Thirupparkadal Nambi

ABSTRACT

The process of globalization has had a deep impact of the financial markets worldwide. With the
liberalization of the Indian capital markets and relaxation of restrictions on international flow of capital
and trade, it is likely to expect the Indian stock market to be integrated with other world markets. The
recent policies of our government have given way to many foreign institutional investors to invest in our
stock markets. These policy changes and initiatives would definitely have a profound impact on behavior
of stock markets. The present study aims to test whether the Indian stock market is interdependent on
the American Stock Markets. The New York Stock Exchange is the largest stock exchange in the world
in terms of Market Capitalization. Many Indian companies have listed their companies shares in
America. Hence the extent of cointegration between the major Indian stock exchanges with the
leading stock markets of America like NYSE, S&P500 and the NASDAQ is tested using the Engle Grangler
test of Cointegration. The data is collected for the time period Jan 1st 2000 to 31st Dec 2008. Such
studies will be helpful to understand the extent of dependence of the Indian capital market with
developed markets of the world and will serve as a useful benchmark to understand the status of Indian
capital market in the current scenario.

* Assistant Professor, Directorate of Online and Distance Education,


Anna University, Coimbatore, Jyothipuram, Coimbatore 641 047.
** Senior Lecturer, Guruvayurappan Institute of Management, Navakkarai,
Palakkad Main Road Coimbatore 641 105. 105
JOURNAL OF CONTEMPORARY RESEARCH IN MANAGEMENT
January - March, 2010

Introduction achieve economies of scale. The term stock market


The linkages between the stock markets of the cointegration in this study refers to identifying the
world are increasing over the years due the effect presence of long term dependencies across two
of globalization. The speed of Global integration stock markets.
the intensification of international economic
Stock market cointegration
linkages among nations is high and is bound to
increase in the coming years. Internationalization The present study tries to examine the
of trade and finance, interdependence among cointegration of the Indian stock market in recent
countries and policy changes among nations to suit years, with the major stock markets in the US which
the world order is the norm of the day. The process is said to be one of the developed and sophisticated
of internationalization results in a greater stock of markets in the world. The study of the existence
foreign factors of production within countries of interlinkages among international capital
inviting more foreign investment, technology and markets has serious implications on determining
technology experts. The financial markets around the extent of portfolio diversification as well as
the world have expanded beyond boundaries with macroeconomic policies of individual countries.
money moving from one country to another in form Investors prefer to hold securities from a variety
of loans, FDI, foreign currency markets etc. The of firms because such diversification reduces
international linkage of national money and capital portfolio risk, similarly, investors who buy shares in
markets has also grown rapidly with the removal foreign as well as domestic companies seek to avoid
or relaxation of restrictions on financial flows some market risk and earn returns through global
across national borders, deregulation of financial diversification. Diversification is rewarding since
institutions and international financial innovations. stock indices of different countries are affected by
Technological growth has made a great impact on different factors and hence need not always move
the growth and development of the markets, in the same direction, or be perfectly correlated.
where an investor can view the prices of currencies In the recent years we can see that capital markets
and stock prices twenty four hours a day. in Asia have become the main destination for many
Tremendous changes have taken place in the way investors to invest their money. International
companies operate due to pressures from global capital market relationships, not only have
competition. Companies world wide are implications for portfolio diversification, but also
consolidating their operations, moving to other have important implications on how economic
countries to find and tap new markets, or to policy changes can be initiated at the national level

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A study on cointegration between indian and
american stock markets

for different countries which will have a bearing cointegration with other leading stock markets of
on foreign trade and there by the foreign the world. Investments through the FII route is a
exchanges balances of a country. key integrating factor for markets as the flow of
funds into the market depends on the foreign
In a country like India, where the stock market is institutional investors perception about the
undergoing significant transformation with the domestic stock market and about alternative
liberalization measures, there are also concerns markets, at different points of time. It is this shifting
regarding its exposure to risk in case of a global/ of funds between foreign markets that leads to a
regional crisis, i.e. a need to know how far a kind of long term relationship among markets.
depression or crisis in another market can affect
the Indian stock market in a more and more Objectives of the study
globally integrated environment. Hence, the
The objective of the study is to find out the
analysis of the nature of co- movements or long
cointegration between Indian and American stock
term dependencies with other developed and
markets using the Engle Granger Test of
regional emerging markets would not only give an
Cointegration.
idea of the of possible gains out of portfolio
diversification to be reaped from the Indian market Review of past studies
but also may give some indication of the
With the liberalization of Indian capital markets,
vulnerability of the countrys stock market in case
there have been significant amount of research
of a regional crisis.
carried out to determine the extent of dependence
The liberalization of Indian capital market has led of Indian capital market with its global counter
to more integration of Indian markets with other parts. For the last two or three decades,
stock markets of the world. We see money moving researchers worldwide have shown interest in
in and out of our markets through various options studying the dependence of various stock markets.
like FIIs and Depository receipts. In the present The review of the past studies shows that the
study, we try to determine the degree to which presence or absence of cointegration can throw
there is integration between the Indian stock meaningful insight into the working and policies of
market and American stock markets. Since Indian a particular stock exchange. Few of the research
capital markets are one among the emerging stock articles reviewed for the study are listed below.
markets of the world, there is enough curiosity David (1994) in his working paper studied the
among researchers to identify the extent of its market linkages using Cointegration rank test with

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JOURNAL OF CONTEMPORARY RESEARCH IN MANAGEMENT
January - March, 2010

special application to the US Natural Gas Industry. the pair-wise, multiple and fractional
Likelihood based tests for cointegration was cointegrations between the Indian stock market
applied to data from natural gas spot markets. and the developed stock markets such as US, UK
The Johansen method was used to study the spatial and Japan. The findings of the study revealed that
market linkages. The results indicated that the the Indian stock market is statistically, significantly
natural gas spot markets at dispersed locations in co-integrated with stock markets of United States,
the pipeline network are strongly connected. Out United Kingdom and Japan. There is existence of a
of 19 market pairs examined, most of the market unidirectional granger causality running from the
pairs (13) satisfied a more stringent condition for US, UK and Japanese stock markets to the Indian
perfect market integration. Chan, Benton and Min stock markets. Indian stock index and the mature
(1997) conducted a study on integration of stock stock indices form fractionally cointegrated
markets by including 18 nations covering a 32 year relationship in the long run with a common
period. These markets were analyzed both
fractional, nonstationary component and revealed
separately and collectively in regions to test for
the cointegration relationship using the Johansen
the weak form market efficiency. The cross country
method.
market efficiency is tested by using Johansens
cointegration test. The results showed that only
In the recent times the Indian stock market has
small number of stock markets shown evidence of
become more open to the rest of the world and,
cointegration with others. Bala and Mukund
(2001) in their study examined the nature and the relationship between the Indian market and
extent of linkage between the US and the Indian the developed stock markets may keep changing.
stock markets. They used the theory of Hence the current study tries to re-examine the
cointegration to study the interdependence nature of co-movement between Indian market
between the Bombay stock exchange (BSE), the and the American markets.
NYSE and NASDAQ. The data consisted of daily
closing prices for the three indices from January Data & Timeline
1991 through December 1999. The results
supported that the Indian stock market was not The daily stock index returns of Indian and
affected by the movements in US markets for the American markets are chosen for the study. The
entire sample period. Wong, Agarwal and Du Jun daily stock index returns of BSE (India) and
(2004) have empirically investigated the long-run NASDAQ , S&P500 are obtained from their
equilibrium relationship and short-run dynamic respective websites. The analysis and the
linkage between the Indian stock market and the interpretation performed in this study are for a
stock markets in major developed countries by period of 9 years starting from January 1st 2000-
examining the Granger causality relationship and December 31st 2008.

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Methodology for the time series (BSE & NASDAQ) and residuals
are obtained.
The relative strength of linear relationship is
Yt = 0 + 1xt + 2zt + (1)
measured by the Correlation coefficient. The
Engle Granger Test of Cointegration is used to Regress y on x and z. The residuals are obtained
test the stock market relationships of various stock from the Ordinary least square and a Dicky fuller
markets. unit root test is carried out to check for unit root.
If a unit root is not present the residuals are
Test of cointegration stationary and the variables are cointegrated.
Cointegration is a relatively new concept The first difference of the residuals Yt is regressed
introduced by Granger (1983) and Engle and against the first lag of the residual
Granger (1987). Two variables are said to be
cointegrated when a linear combination of the two Y t-1 and sufficient lags of Yt.
variables is stationary implying that there is a long
Yt = (Yt Yt-1) = ut (2)
term relationship existing between them. Lack of
cointegration suggests that no such relationship The results of the unit root test, t-statistics has to
exists. be compared with specially calculated critical
values. If the estimated || exceeds any of these
Null Hypothesis: There is no linear dependence
critical values the null hypothesis that there is no
among the indices of the Bombay Stock Exchange
cointegration among the variables can be rejected.
and the S&P500 - AMERICAN stock exchange.
Else accept the null hypothesis.
Alternate Hypothesis: There is linear dependence For example, the daily closing index values of BSE
among the indices of the Bombay Stock Exchange (India) and NASDAQ composite index (US) are
and the S&P500 AMERICAN stock exchange. taken to see whether there is any relationship
between the Indian stock market and the US
Null Hypothesis: There is no linear dependence
markets. The Engle Granger test of Cointegration
among the indices of the Bombay Stock Exchange
is applied and t values are estimated. In the given
and the NASDAQ-AMERICAN stock exchange.
situation the estimated EG DF statistic is 1.0636.
The Engle-Granger 1%, 5% and 10% critical values
Alternate Hypothesis: There is linear dependence
are -2.5899, -1.9439, and -1.6177. Since the EG
among the indices of the Bombay Stock Exchange
DF statistic is found to be less than the critical value
and the NASDAQ-AMERICAN stock exchange.
specified by Engle and Granger, the Null Hypothesis
Testing for cointegration involves testing the that there is no dependence between the US stock
residuals from an Ordinary Least Square regression markets and the Indian stock markets is accepted.

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January - March, 2010

Analysis and intepretation

The test of cointegration is applied to the BSE SENSEX and the top American stock indices like the S&P
500 and NASDAQ. The results are tabulated.

Table 1. showing Engle Granger Test of Cointegration between NASDAQ-BSE

Index X variable Standard Test T 1% 5% 10%


error statistic EG critical EG critical EG critical
CR DF value value value

-2.5899 -1.9439 -1.6177

BSE-NASDAQ -0.0040 0.0038 -1.0636 ACCEPT ACCEPT ACCEPT

Null Hypothesis (H0) : There is no linear dependence between the indices of the BSE-NASDAQ stock
exchanges.

Alternate Hypothesis (H1): There is linear dependence between the indices of the BSE- NASDAQ stock
exchanges.

The daily closing index values of BSE (India) and NASDAQ (AMERICAN) are taken to see whether there is
any relationship between the Indian stock market and the American markets. The Engle Granger test
of Cointegration is applied and t values are estimated. The critical value for Engle-Granger statistics at
1%, 5% and 10% are -2.5899, -1.9439, and -1.6177 respectively.

For the BSE-NASDAQ stock indices the estimated EG DF (Engle-Grange, Dicky-Fuller) test statistic is -
1.0636. Since the EG DF statistic is found to be lesser than the critical value specified by Engle and
Granger statistics at all levels, the Null Hypothesis that there is no dependency is accepted. We recognize
the view that there is no dependence between the American stock markets and the Indian stock markets.
Chart 1 depicts the comovement of index values of BSE and NASDAQ during the period of study.

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A study on cointegration between indian and
american stock markets

Chart -1 BSE - NASDAQ

Table 2. Showing Engle Granger Test of Cointegration between S&P500 -BSE

Index X variable Standard Test T 1% 5% 10%


error statistic EG critical EG critical EG critical
CR DF value value value

-2.5899 -1.9439 -1.6177

BSE-S&P500 -0.0109 0.0070 -1.5483 ACCEPT ACCEPT ACCEPT

Null Hypothesis (H0): There is no linear dependence between the indices of the BSE-S&P 500 (American)
stock exchanges.

Alternate Hypothesis (H1): There is linear dependence between the indices of the BSE- S&P 500
(American) stock exchanges.

The daily closing index values of BSE (India) and S&P 500 (AMERICAN) are taken to see whether there is
any relationship between the Indian stock market and the American markets. The Engle Granger test
of Cointegration is applied and t values are estimated. The critical value for Engle-Granger statistics at
1%, 5% and 10% are -2.5899, -1.9439, and -1.6177 respectively.

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For the BSE-S&P 500 stock indices the estimated EG DF (Engle-Granger, Dicky-Fuller) test statistic is -
1.5483. Since the EG DF statistic is found to be lesser than the critical value specified by Engle and
Granger statistics at all levels, the Null Hypothesis that there is no dependency is accepted. We recognize
the view that there is no dependence between the American stock markets and the Indian stock
markets. Chart 2 depicts the comovement of index values of BSE and S&P 500 during the period of
study.

Consolidated Results of Engle Granger Test of Cointegration

Sl. No Index Correlation Test 1% 5% 10% Result


Coefficient T statistic
CR DF EG EG EG
critical critical critical
value value value

-2.5899 -1.9439 -1.6177

1 BSE- 0.206 -1.0636 ACCEPT ACCEPT ACCEPT No


NASDAQ Cointegration

2 BSE-S & 0.5857 -1.5483 ACCEPT ACCEPT ACCEPT No


P500 Cointegration
A study on cointegration between indian and
american stock markets

The consolidated results of the Engle Granger test show no cointegration between the BSE-NASDAQ
and BSE-S&P 500. S&P 500 index represents fairly all top companies from various industries while
NASDAQ constitutes the technology companies. The correlation coefficient between the two indices
also shows low level of correlation over the years. The results show empirical evidence of lack of
cointegration or long term dependencies between the Indian and American stock markets.

Conclusion

The cointegration of Indian equity markets with the American markets has been studied using the Engle
Granger test of cointegration. This study has focused on Indian equity markets dependency with the
developed market like the American stock markets. The stock index values (closing prices) are obtained
for the BSE and the top American stock markets and the Engle Granger test of Cointegration is used to
examine the interdependence among these stock markets. Interdependence/dependence was examined
for the period January 1st 2000 Dec 31st 2008. During the period of study the results of the test show
that the Indian Stock Market shows no dependence with the NASDAQ and the S&P 500 confirming the
absence of cointegration between the Indian and American Stock markets.

References
Chan, C. K., Benton, G.E. and Min, S.P., 1997 International Stock Market Efficiency and Integration:
A study of Eighteen Nations, Journal of Business Finance and Accounting, 24(6), July, 0306-686X.

Bala, A. and Mukund, K.S., 2001, Interrelationship between Indian and US Stock Markets, Journal
of Management Research, Vol.1, No.3, May-August, pp.141-148.

David, W., 1994, A Cointegration Rank Test of Market Linkages with an Application to the US
Natural Gas Industry Review of Industrial Organisation 9, 181-191.

Wong, W.K. and Agarwal, A. and Du Jun, 2004, Financial Integration for Indian Stock Market: A
Fractional Co-integration Approach, Finance India, Vol.XVIII, No.4, December, pp.1581-1604.

Damodar Gujarathi, Basic Econometrics, Tata McGraw Hill Edition, New Delhi, 2000, pp.789-
792.

Bodie, Kane, Marcus, Investments, Fourth Edition, Irvin/McGraw-Hill International Edition,


Singapore, 1999.